Mortgage Requirements That Can Make or Break You in 2012

This story is part of an ongoing look into the current state of the lending industry. Over the past few weeks, we have been speaking to mortgage brokers and lenders across the United States.

We’ve asked them about their current practices and standards, as well as any important trends they’ve been seeing within the industry.

Previously, I wrote about what it takes to get the lowest mortgage rates in 2012. Today, we will talk about the basic mortgage requirements needed for approval. In particular, we will look at seven key factors that can make or break your chances of getting a home loan in 2012.

Current Mortgage Requirements for Home Buyers

In reality, there are dozens of individual requirements on the path to mortgage approval. But some are merely a check in the box, a paper shuffle if you will.

State and federal disclosures are a good example. Yes, they are technically mortgage requirements. But there’s not much you need to know about them. Nor do you have much control over them.

The seven items described below deserve a much closer examination. These are the factors that can make or break your chances of getting a home loan in 2012. They’re also things you can control to a certain extent. Here’s what lenders had to say about them during the course of our surveys.

An overview of current mortgage requirements in the U.S.:

Credit Scores — There seems to be a good deal of leeway with this requirement. With that being said, most of the lenders we spoke to were looking for a score of 600 or higher for FHA loans, and 620 or higher for conventional mortgages. This requirement is covered in detail below.

Down Payments — Are you a veteran or active-duty member of the military? If so, you might qualify for a VA loan with no down payment. If you use an FHA loan to buy a house, your down payment could be as low as 3.5%. Conventional mortgages generally require a down payment of at least 5%, and sometimes more.

Debt Ratios — Lenders are most concerned with your combined or “back-end” debt ratio. This is a comparison between your monthly earnings and debt expenditures. If you’ll end up spending more than 45% of your income to cover your debts (including the new mortgage payment), you might have trouble getting approved for a loan. As with most mortgage requirements, there is some wiggle room here.

Funds for Closing — Your lender will check your bank account to make sure you have enough money to cover your closing costs. There are the various fees and charges you’ll accrue during the home-buying process. They can add up to thousands of dollars and are typically due on closing day.

Employment — Obviously, you need a job to qualify for a mortgage loan. That goes without saying (I hope). But many lenders set the bar even higher. They want to see at least two years of steady employment. And they certainly won’t take your word for it. You’ll have to document your employment status as well…

Documents — Borrowers have always been required to document certain aspects of their financial situation. In 2012, however, you can expect more stringent documentation requirements than in the past. A lack of documents can slow the process down at best, and derail it at worst. These include federal tax returns for the last two years, bank statements, pay stubs, employment letters and a list of any other assets you have, to name but a few. Most lenders today want the tax records to be sent directly from the IRS, as opposed to coming from you. So don’t be surprised if they ask you to sign an IRS form 4506 when you apply for the loan.

Cash Reserves — This mortgage requirement is something of a hit or miss. Some lenders will require you to have extra money in the bank at closing, theoretically earmarked for your first few mortgage payments. Other lenders only care that you have enough to cover your down payment and closing costs. Still, it’s something borrowers should be aware of in 2012. You can learn more about cash reserves here and here.

All of these items can make or break your chances of getting a home loan, especially those toward the top of the list. Here’s what lenders had to say about the top four items on this list, during our phone and email conversations of the last few weeks.

1. Credit Scores: Only the “Good” and “Excellent” Need Apply

It’s no secret that mortgage lenders have gotten stricter with their credit-score requirements over the last few years. It has been the subject of countless headlines in both the mainstream and financial media. Today, however, there seems to be a stronger emphasis on credit scores for FHA loans as well. And this may come as a surprise to many borrowers and their real estate agents.

In the years past, the FHA loan was seen as the last resort for home buyers with marred credit. These are people with late payments, debt collections, bankruptcies and other negative events dragging down their FICO numbers. When denied for a conventional mortgage, these borrowers could often find a “side door” through the government-insured FHA mortgage program. But we were surprised to find that most lenders are now setting the bar at a 600 FICO score for FHA borrowers.

This is a two-tiered mortgage requirement that frequently confuses home buyers. The Department of Housing and Urban Development (HUD), which runs the FHA program, says you need a score of at least 500 to obtain one of these loans. But don’t expect to find a lender willing to work with you, if your score is truly in the low to mid 500s. Most banks today impose their own “overlays” on top of HUD’s guidelines, often requiring scores of 600 or higher.

With that being said, borrowers who fall into the 500 – 599 range should not despair. Some of the lenders we queried said they would work with sub-600 home buyers, as long as they had other compensating factors. Translation: If you can cough up 20% or more for a down payment, and you have very little debt, you might still land a home loan with a FICO score south of 600.

2. Down Payments Range from Zero to 20%

Do you need a 20% down payment to qualify for a home loan in 2012? No. Will it help you get approved if you have other factors dragging you down, such as a low credit score? Absolutely. With that being said, most borrowers can still qualify for a mortgage with a much smaller down payment.

The lowest requirements can be found on government-insured mortgages. USDA and VA home loans offer 100% financing, while the increasingly popular FHA loan offers a down payment of 3.5% to qualified borrowers. For a conventional mortgage, you might have to plop down 5% – 20%, depending on your other qualifications.

3. A Warning to the Debt-Laden Borrower

Are you spending nearly half of your monthly income to cover your debts right now? If so, you’ll have a hard time finding a mortgage lender willing to increaseyour debt load. Lenders in 2012 are paying closer attention to the amount of debt a borrower is carrying. The so-called debt ratio is another key mortgage requirement in 2012. And it’s a requirement that has become more rigid over the last couple of years.

Start by adding up all of your debt obligations, particularly those that show up on your credit reports (credit cards, car payments, etc.). Now add in the monthly payment you might take on for a mortgage loan, given the price range you are considering. If the total amount exceeds 50% of your gross monthly income, you might be overreaching. Most lenders will view this as a high-risk loan. As a result, they’ll be more inclined to turn you down, or to slap you with a higher interest rate.

Bonus Graphic: FHA Mortgage Requirements at a Glance

The following graphic was attached to a story we published in January 2012. It is based on a questionnaire we sent to more than two-dozen lenders across the United States. It gives you an idea of what it takes to qualify for an FHA loan in particular. (Note: The FHA program has different, and less rigid, requirements than a conventional mortgage loan.)

Strict or Sensible: The Ongoing Debate About Mortgage Requirements

Are lenders being more sensible with their mortgage requirements these days, or overly strict? It’s a fine line that has drawn endless debate over the last few years. On the one hand, they need to ensure that only financially responsible borrowers get approved for home loans. At the same time, they mustn’t be overly strict to the point of turning away strong buyers.

According to Federal Reserve Chairman Ben Bernanke: “As regulators, we have been very clear to the banks … that we want them to take a balanced approach. We want them to make prudent loans and we don’t want them to turn away creditworthy borrowers.”

In 2012, you can expect lenders to lean toward the conservative side. The stricter mortgage requirements we are seeing today speak for themselves. With that being said, reasonably qualified borrowers should not hesitate to apply for a home loan. If you have decent credit, a bit of money saved up for a down payment, and a steady job, there’s a good chance you can get a mortgage in 2012. You have little to lose by trying — and a lot to gain.